Question

Integrative—Risk

and Valuation   Hamlin Steel Company wishes to determine the value of Craft​ Foundry, a firm that it is considering acquiring for cash. Hamlin wishes to determine the applicable discount rate to use as an input to the​ constant-growth valuation model. ​ Craft's stock is not publicly traded. After studying the required returns of firms similar to Craft that are publicly​ traded, Hamlin believes that an appropriate risk premium on Craft stock is about

8​%.

The​ risk-free rate is currently

5​%.

​ Craft's dividend per share for each of the past 6 years is shown in the following​ table:

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.

a. Given that Craft is expected to pay a dividend of

​$2.82

next​ year, determine the maximum cash price that Hamlin should pay for each share of Craft. ​(Hint: Round the growth rate to the nearest whole​ percent.)

b. Describe the effect on the resulting value of Craft​ from:

​(1) A decrease in its dividend growth rate of​ 2% from that exhibited over the

2014​-2019

period.

​(2) A decrease in its risk premium to

7​%.

THE TABLE

2019   2.66
2018   2.51
2017   2.37
2016   2.23
2015   2.11
2014   1.99

Answer 1

Question:1

a. Given that Craft is expected to pay a dividend of ​$2.82 next​ year, determine the maximum cash price that Hamlin should pay for each share of Craft.

Answer:

Given that,

• The risk premium on Craft stock is about 8​%.
• The​ risk-free rate is currently 5​%.
• The required return on craft's stock = 8​% + 5​% = 13%
• Craft is expected to pay a dividend of ​$2.82 next​ year, so we need to know the growth rate for the dividend.

FV = PV * (1+g)^5

2.66 = 1.99 * (1+g)^5

(1+g)^5 = 2.66/1.99

g = (1.33)^1/5 - 1

Growth rate (g) = 0.0597 or 5.97%

To get the maximum cash price that Hamlin should pay for each share of Craft is determined if Craft is expected to pay a dividend of ​$2.82 next​ year.

Maximum price = [Next year dividend / ( required return - growth rate)]

= [ $2.82 / (13% - 5.97%)]

= $ 40.11

Question:2

b. Describe the effect on the resulting value of Craft​ from:

​(1) A decrease in its dividend growth rate of​ 2% from that exhibited over the 2014​-2019.

Answer:

Here, there is a decrease in its dividend growth rate of​ 2%

Then the actual growth rate = 5.97% - 2% = 3.97%

So, the dividend for the next year = $2.66 * (1 + 0.0397) = $ 2.76.

Now, the price will change to = [Next year dividend / ( required return - growth rate)]

= [$ 2.76 / ( 13% - 3.97%)]

= $ 30.56

​(2) A decrease in its risk premium to 7​%.

Answer:

Here the risk premium is decreased by 7%

So, the required return = 7% + 5% = 12%

Now, the price will change to = [Next year dividend / ( required return - growth rate)]

=[ $2.82 / (12% - 5.97%)]

= $ 46.77